China’s stock markets have been experiencing a strong rally since last week, and the upward momentum seems to be building further. We see five key drivers for the recent rally.
Firstly, recent state media’s stance: Last Monday’s front-page editorial in the state-owned China Securities Journal said it was important to foster a “healthy bull market”. China’s CSI 300 index surged to a record five-year high while both the daily turnover and the balance of margin financing for the A-share market picked up significantly, indicating strong retail demand for stocks. In view of the rally’s abnormal speed, Chinese officials’ stance switched to a more rational tone in the last few days in an attempt to engineer a steady bull market. A pair of government-owned funds announced plans to trim holdings of stocks while the state media warned about the dangers of a ‘crazy’ bull market. In addition, according to the financial regulators of the Financial Stability Development Committee, China will show ‘zero tolerance’ towards securities and accounting fraud and will step up crackdowns on major capital-market crimes.
Secondly, the change in inter-regional allocation: With the virus under control domestically, coupled with improving corporate earnings and better economic data, some investors have developed a temporary preference for the Chinese equity markets, where the pandemic risk appears to be more effectively contained. Northbound flows into A-shares via the Stock Connect have risen meaningfully in the past few weeks, suggesting a more bullish sentiment among foreign investors.
Thirdly, further A-share inclusion as FTSE Russell increased the A-share inclusion factor from 17.5% to 25%, with A-shares now representing ~6% of the FTSE Emerging Index. This helped to build momentum for more passive inflows.
Fourthly, a liquidity-driven rally and the fear of missing out: Recent global quantitative easing policies and rising domestic savings have led money managers to gravitate toward A-shares. Since 2019, domestic household deposits have grown at a rate of 13-14% year-over-year, amid ongoing property market controls and precautionary motives during the economic downturn. Further, in the past few months, shutdowns and fears over jobs have led domestic households to increase their savings. According to the People’s Bank of China (PBoC), household deposits rose to RMB 88trillion (tn) at the start of May, compared to less than RMB 82tn in December. Hence, when the A-share rally started, many rushed in with the fear of missing out.
Finally, a change in investor behavior: Millennials have grown to become the new generation of onshore investors. They have less experience in the market, may be more willing to take risks, have less family burden, and perhaps a greater eagerness to buy property. This change in investor behavior might also partially explain the recent quick onshore rally.
EXHIBIT 1: Volatility of Chinese markets highlights the importance of international diversification
For the real economy, the wealth effect of surging stocks could encourage more consumer spending, helping underpin the economic recovery. The recent rally should also lead to an increase in business investment amid improving investor sentiment and easier access to funding through Initial Public Offerings and refinancing. However, the strong surge in Chinese equities may prevent authorities from continuing its policy easing, which is necessary for a recovery from the COVID-19 shock.
The recent rally has brought up uncomfortable parallels with the 2015 A-share bubble. However, the backdrop in terms of global policy stance and valuations are quite different. Back in 2015, the Federal Reserve was planning for a liftoff in the federal funds rate, while the PBoC was contracting its monetary base and draining its credit support. This is in contrast to the current ongoing massive policy easing, which should be conducive for growth and asset prices. Also, unlike 2015 where valuations were expensive (22.5x, at the peak on June 15, 2015), current CSI 300 index valuations are much more reasonable at 18.2x compared with the long-term 10-year average of 14.0x. Obviously the recent quick rise may imply some pressure in the near term. However, the regulators are taking actions to crackdown on over-the-counter margin trading activities to prevent the market from becoming overheated.
We remain constructive on Chinese equities as we continue to see pockets of opportunities. However, as the uncertainties sustain within the global and local economy, investors need to be selective and focused on fundamentals. Moreover, as seen in Exhibit 1, the volatility in returns of Chinese markets highlight the importance of international diversification.
There are also a few downside risks that investors should pay attention to. First is the potential second wave of coronavirus infections. Any uptick in coronavirus cases may again pose a risk to domestic consumer sentiment, bringing headwinds to small and medium-sized enterprises and export-oriented firms. Secondly, geopolitics remains a constant risk for the markets, especially any significant escalation in U.S.-China tensions as we approach the last 100 days of the U.S. presidential elections. Lastly, the August interim results will be critical in assessing individual company’s upside and downside risks. Investors are advised to continue taking a more active approach in sector and company selection.